P/E Ratios: They Ain't What They Used to Be!

Price divided by earnings, right? Simple. No.

When you cannot agree on how to define the term "earnings" anymore, then it isn't simple. In the last few days, we have seen some pretty big guns in academic and "real world" finance utterly unable to agree on what the current P/E of the S&P 500 index "is" now. One man, who knows more than I do, says that earnings should be capitalization-weighted. The guy in charge of the S&P's own computation of the index's P/E, says, more politely, "Bosh!"

Forward-looking or, um, "not-forward-looking"? One extremely bright man who runs a hedge-fund-of-funds says that on his projection of very low earnings, we are headed downward, much lower, before the bear market bottoms out. Others, including one noted "perma-bear", are now very bullish, for about the first time in anyone's living memory, and . (He's been around a while.)

Can this humble (I'm so humble that I'm unknown,) advisor offer a thought or two on P/E ratios? Thank you, I will.

1. Earnings of individual companies are less reliable than they once were. There is scope under the accounting rules, despite what the accounting profession says, for company management to smooth out income in normal years, and to do things like really throwing in the kitchen sink in a bad year, so as to look better later.

2. Forward-looking earnings are estimates only. Evidence-based estimates, but still estimates.

3. P/Es of indexes are just composites, however you calculate them, of the individual constituants of the index. And they are less reliable measures of value at market extremes, both tops and bottoms. Take them with a big grain of salt. Beware of obvious extremes, like those during the dot.com or tech bubble. They are unsustainable. Perennially profitable companies, running current losses, cannot have meaningful P/Es. It does not compute. So how meaningful is today's S&P 500's P/E, no matter how you try to calculate it?

4. But what about this market crash? P/Es were not obviously at ridiculously high levels. We just had what one very clear-sighted observer called a "liquidity bubble". Individual investors' behavior was not the cause of this last crash. Crashes do need a catalyst, something to sufficiently upset the status quo. See point 5 below. Institutions, both investment banks and other players, like hedge funds, were in my opinion the primary cause. Bear Sterns had what? Something over 30:1 leverage. Others were about as bad or even worse. Borrowed money, leverage, deployed in "safe, risk-controlled" strategies, like very highly-levered huge positions in CMOs and CDOs. Bye bye, Bear Stearns, and friends. but they were hedged! Yeah, right. Hedges can fail when markets aren't working or if the other party is himself in too deep. And now we find out that the European banks were more levered than Bear Stearns? That, if so, is trouble, with a capital T. If Euroland has a really bad time, they tend to spawn very big conflicts over there. Russia is economically weak now, but Putin is no fan of liberty, and wants Russia's old vassal states back. Germany was weak too, in the early thirties. China and the rest of Asia are not without large problems now either. And trouble in a globalized world, tends to flow around, back and forth, rather like a tsunami.

4.1. But why did all asset classes and equities of all the developed and emerging markets fall? Simple, in hindsight. Massively overlevered institutional investers, in a state of crisis, had to sell whatever could be sold, to meet lenders' demands for payment, and in the case of hedge and mutual funds, to meet the horrified retail investors' demand for redemptions. So, the levered players dragged down everything except sovereign debt, such as US treasury securuties.

5. But wasn't it really the housing bubble, and the politically-motivated lowering of mortgage lending standards, and lax bond-rating and institutional credit-rating practices which caused all this? That was bad, bad indeed. And it would have all blown up in due course anyway. And yes, this was the catalyst.

And that's how we got where we are.

Oh. P/Es. They are just a tool, and not always a very good one.

"AmeriCredit Raises $750 Million in Subprime Auto-Loan Bond Sale" (Bloomberg)

It is very good to read this. Perhaps a harbinger of better things to come. When subprime debt can again be bought and sold, then it may be time to revisit some of the asset writedowns. Such upward revaluations could be seen by the markets as a significant positive, of course.

Bloomberg.com: Worldwide

Extremely Important Read: Mahalanobis' "Estimating exposures in credit derivatives"

He says it better than I can. How's that for humility? I have been of the opinion that some of the subprime-related asset writedowns have been ludicrously exaggerated. When the dust settles, and the writedowns get adjusted to reality, will the markets suddenly get rather happy? Will heavily-impacted financials get wind in their sails? I suspect they will.


Mahalanobis

at an inflexion point in subprime crisis? Perhaps

Hat tip to Fintag on this one.

A couple of rather powerful thoughts: "...investors should be canny and careful, and take little for granted. My own strategy is to invest in sound assets and simply hold onto them. That’s because the other relevant phenomenon about crises, is the system ultimately recovers. If you have the staying power, you will probably do fine." This is how investing, real investing, is done. You establish an appropriate asset allocation for you, in full consideration of your own time horizon and ability to bear market risk. You stick to it. If you do not understand how to do this, you should study some, or you gird up your loins and go find yourself a trustworthy, competent adviser. He can.

A trustworthy adviser has an investment approach consistent with objective academic investment research, not Wall Street's age-old refrain: "We're sooo smart, we can out-research and out-invest and out-trade everyone else for you! It must be so. Just look at my nice watch and expensive office!"



Bruner: We are at an inflexion point in subprime crisis - General News - FinanceAsia.com - The network for financial decision makers

Bloomberg's strangest headline of the day, "It's Time to Meet the Subprime Devil We Don't Know: Caroline Baum"

Is this perhaps a slightly awkward headline? I always figured she was perfectly nice. (Just kidding now.)

Seriously, she has a very substantial point: Is the lack of transparency which goes with certain investments such as some mortgage-backed securities, sufficient to make it very difficult to evaluate the risks present in the financial markets? Sufficient to render problematical proper evaluation of the risk present in heavily-leveraged, quantitatively-driven portfolios of such investments? Evidently.

Sufficient even perhaps to alter the "riskiness", i.e., volatility, of even other asset classes? In the short run, apparently. Did Stephen King ever write anything as scary as that?


Bloomberg.com

IHT: 'Size doesn't keep Goldman fund from gyrating with market' -- Or is it, gyrating the market?

So, is it a fair question, if your portfolio was down last week, was it largely Goldman's hedge fund's selling to raise cash that did it for you? Presumably, anticipating big redemptions, with Global Alpha now down something like 33 percent, perhaps more, over last year and this YTD, and since there is now rather limited demand for subprime-"backed" debt, needing to sell genuinely marketable securities, down, down, we go.


Size doesn't keep Goldman fund from gyrating with market - International Herald Tribune

Vindication isn't so great.

Anyone who's read this blog before knows that I don't think much of hedge funds. Re: the Goldman story, this is of course unconfirmed as of this time. Perhaps it's not that bad. Nobody would want this to happen to folks.
Bloomberg.com: "Goldman's Global Alpha falls 26% in 2007, People Say" So, hedge funds are just a great way to go, huh? When the redemptions have been paid out, and the investors lick their wounds, how will they come back in? One of the hedge funds which come out relatively unscathed? This time. Or in a somewhat more traditional investment approach?

You call that a sell-off? -- MarketWatch

Once in a while you see a statement which is just stunningly strange:

"In general, stocks are not cheap, especially if you consider that corporate profit margins are hitting all-time highs."

If earnings are high, then how is it that stocks are expensive?

Should you care? Should you act if you think stocks are expensive, or cheap? Market timers have no rational basis for expecting to beat out all the other market timers. N-O-N-E. Acting with money without some rational, defensible basis for what you are doing is not rational. Investors, not traders, as a group win. The objective research, as a body of research, bears that out.

Only if you think you have some genuine edge, would you rationally get into trading in general. No disclosed trading strategy has survived rigorous research to see if it works. Perhaps presence of a trading edge explains the existence of brokerage and institutional trading desks. For a brokerage to suggest it is working for you, while it is trading against you, is not my idea of fiduciary behavior. But, as an old friend, the first real portfolio manager I ever knew, once said to me, long ago in the '70s, when I expressed shock at something I had seen, "...but who ever told you that brokers are in business to serve the best interest of their clients?"

You call that a sell-off? - MarketWatch

China at 45 Times Earnings = Bubble

Yes China's economy is growing. Its' financial markets may go on up higher for some time. But no, it cannot grow fast enough to justify such valuations. Period. Simple enough? For you and for me, um-hum. For all the speculators out there praying for greater fools to keep coming in, and for investing newbies, 'fraid not. We are living in interesting times.


Bloomberg.com: Exclusive

Markets Made 'Unchanged' Into 20 Percent Gain: Chet Currier of Bloomberg

"If this steady-as-you-go spell has been tough on traders, it has gone down just fine with buy-and-hold investors in the stock market and stock mutual funds." -- Mr. Currier. Pithy and true. If you have been trying to game the Fed, building some sort of trading approach around what will, you hope, go up when an interest rate cut comes, then you haven't made much, or maybe you've even lost ground. If you were just well-invested, well allocated, and so on, you've reason to be smiling as you read this.

Is there a lesson in this? You bet. What has worked in investing continues to work.



Bloomberg.com: Opinion

Stocks in S&P still reasonably valued, no bubble here.

I have already read one "expert's" comment that the new S&P record 'makes him nervous'. Per the linked article, the S&P's stocks are 45 % cheaper than in 2000. No bubble here. Let's move forward.



Bloomberg.com: Exclusive

Grantham's 'All asset classes everywhere bubble'. It's Ridiculous!

What's ridiculous about it? Well. let's start with a rather bizarre quote from TSC writer Brett Arends: "As Grantham points out, a bubble needs two things: excellent fundamentals and easy money." I am sorry, but bubbles involve extremes of valuation, not excellent fundamentals.

Arends again, describing Grantham's thinking: "Grantham concludes that every asset class is expensive today compared with historic averages...." US large-cap growth-oriented stocks are not so expensive.

There is a bit of discussion of whether high current earnings are good support for high stock prices, and Grantham just is not impressed. But those earnings are what they are. They are reflective of the current economy.

"The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds," Grantham warned. "Since no similar global event has occurred before, the stresses to the system are likely to be unexpected." Surely it is a risky world. And there is a part of all of us which strives to be prudent. But prudence is only truly so if it based upon reality. Grantham just has not made his case.



Jeremy Grantham: All the World's a Bubble

The Correction has been Corrected!

So, if the market has made back the ground lost due to the "correction" -- I despise that word -- does that mean that the correction was incorrect? Mark Hulbert discusses it.



February-March correction now completely overcome - MarketWatch

Bloomberg: "Heebner Says Home Prices May Fall 20% Amid Bad Loans"

Crucial words in the quote, missing from sensationalistic headline: "... in some markets, he said."

Big difference! Seriously, even if the prediction is correct, wouldn't it just be a case of reversion to the mean? Really now, home price shot up so much, so fast, well, wouldn't you expect some likelihood of this? Remember all the articles about the "real estate bubble"? Bubbles pop.



Bloomberg.com: Worldwide

Bloomberg's Hauck & Xydias Discuss Low Global Correlations

This is important to you because when many global financial markets seem to be moving more closely together, investors and speculators both take note. We respond, or at least are concerned, in somewhat different ways. The diversification of foreign investing is important to each, but globally-diversified investors don't necessarily need to respond in a short-term-focused way. There are times when correlations track along more closely, like now, and there are periods when markets in different places move up or down together, but in differing degrees, and there are times when the correlations even become negative for a time. This can continue for extended periods of time. No sweat, to a more strategically-oriented investor. More tactically-oriented folks, and the speculatively-inclined, like those described in the Bloomberg article, always on the lookout for a way to shorter-term gains, can get somewhat lathered up over this, but that is the way things are, for now, and perhaps for awhile.



Bloomberg.com: Exclusive

Amen, sister, II: Bloomberg's Baum has a few more apt words on China

Bloomberg.com: Opinion

I concur: "China's stock exchange has more in common with a casino than a marketplace." More, "China's market lacks transparency and is fueled by rumor and speculation."

A caveat: (she writes:) "Chinese investors have gone back to doing whatever it is they do, which is buy stocks. With increased distance from the events of last week, U.S. investors are starting to look at their own house of cards, not to the roulette wheel that is China's market." Now, I would not refer to the US market as a "house of cards". It isn't. A sad blemish on an otherwise excellent article.

Ben Stein's column, w/ a rather mild critique

The column is titled "Keeping your Cool in a Shaky Market", which is pretty timely and excellent advice in itself. The comments ( I didn't read them all,) are a hoot. Either the commenter is a trader/market timer, and gives Ben's words one star of a possible five, or is more of an investor, and gives four or five stars. There is something to note in this! One commenter calls Ben's counsel "basic stuff". My thought: it is out of sound, dogged, tenacious implementation of good, valid "basic stuff" in investing that you pull ahead. Don't ever hold "basic stuff" in contempt. Ever. You get away from it at your own risk. You don't have to agree with me or with Mr. Stein on all the details. But there are principles which have worked in investing.

Warren Buffett's name is thrown into this melee by one commenter as one who "was smart enough to sell last month when the market was increasing. People will think I'm crazy but you can time the market and the party is over. It's 1929 all over again." Aarrrghh.

Amen, sister: Caroline Baum's Bloomberg article: Stock Market Slide Spawns Tales From the Crypt

Some people have the ability to discern foolishness when they hear it. Ms. Baum has a few choice words to say about media commentary on the markets this week.


Bloomberg.com: Opinion

Words You Won't See Me Using Much, and Neither Should You

"Correction" Does it mean that something about the markets was wrong, and now it is right? All the word (poorly) describes is that the market went down, presumably when hedge funds and other short sellers speculatively attacked it en masse, in the hope that thousands of fools would follow them in selling, then they could buy back in to cover their positions.

"Support" This is the peculiar idea that the market has a mystical boundary at some lower point where buyers will appear and stop the price of a stock from falling further, unless they don't. A form of superstition known as numerology, er, no, technical analysis.

"Resistance" This is the mystical upper boundary for how far a stock's price can rise, because it is the level where it peaked before, one or more times. You see, it is where sellers are thought to appear from the woods and sell your stock, unless they don't. Another doctrine of the superstition of technical analysis.

"Overbought"; "Oversold" This is the belief that if your technical indicators did not work up until now, because all those fools did not know how to read the charts like you, then doom awaits them when the technical mojo gets to working.

The dumbest thing I heard today, from one of the usually astute guests on Larry Kudlow's show, "We needed a correction." Really. Investors do not need a "correction". In fact our long-term orientation armors us somewhat against market volatility. Traders, short-term-oriented folks, might need a correction; hedge funds oriented to short selling will do their utmost with their monstrous lines of credit to create "corrections". I think it is fair to say that if you are invested in such a fund, you should understand that in a sense their interest lies in damaging the rest of your portfolio as much as they can, whenever they can.

The Markets Today -- A few Thoughts on China, and the USA, Mostly

It's interesting. The drop of the Shanghai Composite Index should be no shock, as it has been going up so fast for so long, looking ripe for some possible downward volatility. So we have some. What's important about this? Volatility happens. Speculators lose money, mostly. I really believe that what is most important is long-term in nature. I would hope that if China is fortunate enough and its leaders wise enough to avoid messing up their great possibilities, (and I think they may be,) this century can be the beginning of a golden age for China and indeed, for many of the emerging market nations. But human history show us that the leaders of great nations are too often not much wiser than the rest of us.

There have always been spectacular downs as well as ups -- much volatility -- as market economies mature and grow stronger.

Consider Hong Kong, over the last forty years. Mark Mobius' book, Mobius on Emerging Markets, has a discussion of the huge volatility, the sustained very high economic growth rate, and the great rewards in terms of investor wealth which came to patient, careful, (dare I add diversified) investors. Hong Kong can be the model for even a huge nation like China.

So what would I, an individual American, hope to see from China over the rest of my lifetime? Economic growth and freedom, and a sense of responsibility to handle well the marvelous possibilities still opening up before the eyes of the world. It would seem to me that there is no need at all for aggressive, substantial expansion of military forces. Or for forceful resolution of the Taiwan issue. I am far removed from a position of influence, but my friendly counsel would be to seek all possible ways to defuse tensions, strengthen trust, reward that trust well, and to build on the many things which are shared between them, cultural and otherwise. I would think it would be very wise even to unilaterally renounce the use of violence against Taiwan. Peace, shared prosperity, and a genuine sense of enduring brotherhood are the best ways to bring people together. If Germany can be peacefully reunited, so can China someday. So can Korea, for that matter.

Chinese investors would be very well rewarded for avoiding speculative behavior; that is not a good way to build anything. they should seek ways to invest patiently, in well-diversified ways, at minimal expense, and also invest globally. While I am not expert on the details of the matter, I understand that there are limitations on the ability of small China investors to invest in the securities of other countries. I would hope that the need for such limitations would recede.

On the US markets today. I find remarkable the behavior of the traders, who take something like today's China market news as an invitation to, well pardon me, but to start trying to take the other emerging markets, the US and other developed markets down as well. There is no rationality visible in this, at least to a much less tactically-oriented fellow like me. If you are irrational enough to think that you can out-trade all the other nuts, er, speculators out there, I guess you just do not need something like a reasonable basis for all that buying and selling.